Cause for Concern: The Stock Market has Bad Breadth

History suggests a bearish signal is now flashing

The number of stocks in the S&P 500 (SPY) above their 200 day moving averages is now below 70%, the lowest amount in over a year. The last time the % was this low, the S&P was on its way to declining 15% from September to November 2012.

If the S&P (VOO) were to fall a similar level this time, it would mean further declines below $1600.

Should we heed the declining breadth warning?

Breadth

The stock market’s breadth is a way to look into the internals of the market and get a read on how healthy it is. In bull markets, typically most stocks rise along with breadth, confirming the trend. In bear markets, the majority of stocks fall.

There are many ways to measure breadth but one way is looking at the % of stocks trading above their moving averages. If the market is rising but less and less stocks are also rising, that is a warning sign that internals are not as strong as the indices suggest.

For example, during the market’s last major pullback, the May-Aug 2011 decline, the market’s breadth shrunk to only 9% of companies trading above their 200 day moving averages. Breadth was declining as was the market, a confirmation of its overall weakness.

In other words there was little protection in individual stocks as most were also in confirmed downtrends.

Breadth Warnings

Breadth can be helpful as a warning sign as we noticed in our 1/20/14 Technical Forecast which we publish twice each week. In that update for our subscribers we warned this time of declining breadth in the number of stocks above their 50 day moving averages,

“The % of stocks above their 50 day moving averages peaked in February and again in May along with new all time highs. Since then though, the peaks have not shown as much participation and display a market that makes new all time highs, but on the backs of less and less stocks. A breakdown below 60% accompanied all the market pullbacks in 2013 and again will be a warning that a majority of stocks are nearing downtrends and a larger selloff is likely.”

A decline below 60% occurred on Thursday, 1/23. The markets (IWM) then fell another 3% that following Friday and into the following week. We were able to warn subscribers of the risks in the market due to declining participation in the uptrend as a full 40% of stocks fell below their 50 day moving averages, constituting downtrends. (For more information on another indicator we are following see my article on the put/call ratio and how it also helped warn our subscribers of the current market pullback.)

The number of stocks now below their 50 day moving average is well below 50%, implying more than half of stocks are now in short term downtrends.

Our Radar Watch

The following chart is similar to the one provided on 1/20 to our subscribers and shows the percentage of stocks above their 200 day moving average is at 70%, meaning 30% of stocks have now entered longer term downtrends, the most since 2012.

But, the blue arrow also identifies that the % of stocks above their 200 day moving average has been steadily sliding, even as the market has steadily made new all time highs. This is a big warning that the market is rising on less and less participation, being pulled higher by less and less companies. Not healthy.

(Also see how falling lumber prices warned us of homebuilder (XHB) and construction stocks (ITB) making their highs back in May. Homebuilders, along with REITs, (VNQ) still have not recovered.)

This is the first time since 2012 this ratio fell below 70%. The last time breadth was this negative the markets went on to make 15%+ downside corrections. This is a sign the current selloff (SDS) is already different from any of the past year and may be headed still lower.

The ETF Profit Strategy Newsletter uses technical, sentiment, and fundamental analysis to stay ahead of the market’s trends. The market’s breadth has been sliding as the market made new highs, a warning that the long awaited pullback may be upon us. Once the 1768 price level failed, it opened the doors to further declines. Find out what other key price levels we’re watching.